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Full text of "What are patronage refunds?"



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What are 

patronage 

refunds? 

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UNIV. OF FL 

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EPOWTCY/ 



U.S. DEPARTMENT OF AGRICULTURE 
FARMER COOPERATIVE SERVICE 
FCS INFORMATION 34 



CONTENTS 

Page 

Basic Requirements 2 

Relation of patronage refunds to 

cooperative features 4 

Member ownership and control 5 

Service at cost 5 

Limited returns on capital 5 

Obligation to finance 6 



FCS Information 34 Revised April 1977 



What are 

patronage 

refunds? 



David Volkin 

Senior Agricultural Economist, 

Organization and Finance 

Patronage refunds or patronage dividends 
are terms distinctive to cooperatives. Rebate is 
the term more often used in other businesses. 

The Internal Revenue Code of 1954 as 
amended, 1 defines a "patronage dividend" as 
". . . an amount paid to a patron by an 
organization, to which part I of this subchapter 
applies — 

1. on the basis of quantity or value of busi- 
ness done with or for such patron, 

2. under an obligation of such organization 
to pay such amount which obligation existed 
before the organization received the amount so 
paid, and 

3. which is determined by reference to the 
net earnings of the organization from business 
done with or for its patrons. 

Such term does not include any amount Daid 
to a patron to the extent that: 

A) such amount is out of earnings other than 
from business done with or for patrons, or 

B) such amount is out of earnings from busi- 
ness done with or for other patrons to whom no 
amounts are paid, or to whom smaller amounts 
are paid with respect to substantially identical 
transactions." 

We use the Internal Revenue Service (IRS) 
definition as a basis for achieving some under- 
standing of the term "patronage refund" because 
the IRS definition provides legal status and 
guidelines for implementing the cooperative con- 
cept of operating on a "service at cost" basis. We 
prefer to use the term "refund" rather than "divi- 



'See Section 1 . 1 388-1 (a)( 1 ) of the income tax 
regulations. 



dend" because the latter carries the connotation 
of a return on capital where the term "refund" 
carries more of a "rebate" connotation. And ref- 
erence to the IRS language makes clear that a 
return on capital is not intended by the IRS defi- 
nition. 

BASIC REQUIREMENTS 

The IRS definition does point up certain key 
requirements that should be clarified and empha- 
sized. 

First, the definition refers to patrons rather 
than members of an organization operating on a 
cooperative basis. And because a key element of 
patronage refunds requires that they be made 
pursuant to a contractual arrangement between 
the cooperative and its patrons, there exists a 
basis for either including or excluding certain 
classes of patrons from such contractual arrange- 
ment. Thus it is possible to include only members 
as recipients of patronage refunds by virtue of 
their compliance with the cooperative's 
organization papers, and to include or exclude 
nonmembers through separate patronage refund 
agreements. 

Second, an important difference that dis- 
tinguishes an organization that operates as a 
cooperative from the noncooperative business 
organization is the requirement that such distri- 
butions are based on the ". . . quantity or value 
of business done with or for such patron." This 
requirement implements the cooperative's central 
objective of distributing financial benefits to 
patrons based on their use of the cooperative's 
services rather than on the basis of their 
investment in the cooperative's capital structure. 

Third, because cooperatives may provide 
many varied services and patrons may vary 
widely in the nature and scope of their patron- 
age, it would be reasonable from a patron's point 
of view for a cooperative to departmentalize its 
operations and its accounting procedures to more 
accurately determine the amounts available for 
distribution as patronage refunds based on the 
specific transactions of patrons. 

Fourth, the IRS definition makes it clear 



that patronage refunds arise only from trans- 
actions with its patrons. Thus, income that a 
cooperative receives from so-called "unrelated" 
activities are per se not derived from patronage 
transactions and would not be included in the 
IRS definition of a patronage refund. Such dis- 
tributions, however, may be computed and dis- 
tributed on a patronage basis in compliance with 
Section 521 of the IRS Code. Examples of non- 
patronage income would include income items 
such as rental income, interest income, and capi- 
tal gains. 

Fifth, the obligation of the cooperative to 
pay patronage refunds must exist before any 
patronage transaction takes place. Thus, both the 
cooperative and its patrons have knowledge prior 
to any transaction that net margins derived from 
the transaction will be paid in whole or in part as 
a patronage refund. A typical bylaw provision 
that sets forth the obligatory nature of a patron- 
age refund reads as follows: 

"The association is obligated to make pay- 
ments of all such amounts in excess of operating 
costs and expenses in cash refunds or by credits 
to a capital account for each patron." 

Under such a preexisting mandatory obli- 
gation to pay patronage refunds, it is clear that a 
cooperative's board of directors has no dis- 
cretionary posture as to whether the cooperative 
will or will not pay a patronage refund. That 
decision already exists. The board's purview lies 
only in the decision area of the time and form of 
the patronage refund, not //it will be made. 

The preexisting obligation must be in 
enforceable written form. Valid examples include 
a cooperative's bylaws, articles of incorporation, 
marketing agreement, sales receipt, or other writ- 
ten contract obligating the association to make 
such payment. If a State law makes such patron- 
age refunds mandatory, that law also is consid- 
ered as a valid obligation. 

Sixth, patronage refunds are distributions of 
net earnings (net margins or net savings) derived 
from business transactions with or for patrons. A 
question as to what constitutes "net earnings" 
may come up. The Federal income tax regu- 
lations define net earnings as ". . . the excess of 



amounts retained (or assessed) by the 
organization to cover expenses or other items 
over the amount of such expenses or other 
items." 2 

Under some circumstances, marketing coop- 
eratives may operate in such a manner as to 
return all sales proceeds, less all expenses, to its 
patrons. Because such a cooperative generates no 
net earnings, it will pay no patronage refunds. At 
the same time, however, it may build its capital 
structure by patrons furnishing capital evidenced 
by per-unit capital retain certificates, based on 
the dollar value or physical volume of products 
marketed through the cooperative. Such capital 
is not furnished "by reference to the net earnings 
of the organization." Rather it is furnished on 
the basis of the patrons' marketing transactions 
through the cooperative. 

Seventh, inherent in most definitions of what 
a cooperative is and the principles that dis- 
tinguish a cooperative from a noncooperative 
form of business organization is the concept of 
equitability or fairness. The IRS definition pre- 
serves and reflects that concern by emphasizing 
that the term "patronage refund" does not 
include distributions derived from earnings from 
patronage transaction with patrons to whom the 
cooperative paid no patronage refunds or tc 
whom the cooperative paid smaller amounts wit* 
respect to substantially identical transactions. 

Relation of Patronage Refunds 
To Cooperative Features 

How do the various features and key ele 
ments that explain patronage refunds relate tc 
and have an impact on basic cooperative charac- 
teristics? 

Four characteristics are hallmarks of the 
cooperative form of organization. They are: 

1) Member ownership and control 

2) Service at cost 

3) Limited returns on capital 

4) Obligation to finance 



2 See Section 1. l388-l(aXiii) of the regulations. 



Member Ownership and Control 

As patrons increase their equity interest in 
their cooperatives as a result of receiving patron- 
age distributions in the form of allocated equi- 
ties, their ownership interest increases. But their 
patronage, the resulting patronage allocations, 
other forms of participation in the affairs of their 
cooperative and, in fact, their loyalties, are 
unequal. As a result, some cooperatives, as a 
means of achieving their perceived interpretation 
of equitability adopt a system of weighted voting 
that takes into account members' investments 
arising primarily from their proportionate use of 
their association. 

Based on this analysis, many associations 
have adopted weighted or proportional voting in 
preference to the one-member, one-vote method. 
In other words, patronage refunds appear to con- 
tribute to a shift from democratic control to so- 
called equitable control. 



Service at Cost 

Patronage refunds strengthen the operation- 
at-cost concept. One point of view is that because 
costs cannot be estimated accurately in advance, 
patrons of a cooperative usually pay the "going 
or competitive price" for goods or services and 
generally receive an advance or the going market 
price for products marketed that is less than the 
actual value of the product. Adjustments are 
made at the end of the year when costs are 
known. The amount of any necessary adjustment 
then goes to member-patrons as refunds based on 
patronage, thus reducing the operation to a cost 
basis. The refund results in the cooperative not 
making a profit for itself nor for nonpatron 
investors. 



Limited Returns on Capital 

Members of a cooperative are primarily 
interested in the benefits they derive as patrons 
of the organization. Because benefits in a cooper- 
ative are distributed to patrons on the basis of 



their use of its services, such benefits do not 
enhance the value of shares of stock or other 
equity capital, or provide a return on invested 
capital. 

Hence, members of a cooperative must pro- 
vide most of its capital either by direct sub- 
scription or by investment of their patronage 
allocations. The incentives that cause persons to 
invest in corporate stocks are not present in the 
case of cooperative stock. For this reason, the 
capital of a cooperative, for the most part, can 
come only from its member-patrons. 

On the other hand, as equities fall into hands 
of persons no longer using the cooperative's ser- 
vice, some mechanism should be triggered to 
either redeem such equities or to shift the charac- 
ter of such equities to provide a return to their 
holders. 

Obligation to Finance 

A cooperative is organized for the benefit of 
its members as patrons and not as investors. A 
cooperative patron's return on investment is reck- 
oned in terms of improvement in farm income by 
use of the cooperative's services, not in terms of 
returns on capital furnished. Member-patrons are 
the persons primarily interested in and benefiting 
from the success of the enterprise. As they use its 
services, they assume the basic responsibility of 
providing capital through their investment of 
their share of the earnings derived from their 
patronage transactions. 

But as patronage terminates so also does the 
financing responsibility end. Unless a cooperative 
adopts some plan or system to redeem equities 
held by persons who no longer patronize their 
cooperative, an anomalous situation of an 
increasing amount of ownership capital being 
held by inactive farmer-patrons grows. 

Thus, patronage refunds are a natural and 
consistent ingredient to assure that member- 
patrons finance their cooperative. But unless 
equity redemption procedures are adopted, they 
are also a means of permitting equity capital to 
fall increasingly into the hands of those who no 
longer use the cooperative's services. 






OTHER PUBLICATIONS AVAILABLE 



Handling Net Margins Under Federal Tax Law. 
FCS Information 39. Revised September 1976. 
8 pp. 



Using Co-op Members' Money. C. H. Kirkman, 
Jr. FCS Information 79. Revised 1975. 16 pp. 



Federal Income Taxes. Part II — Legal Phases of 
Farmer Cooperatives. Morrison Neely. FCS 
Information 100. May 1976. 126 pp. 

How Farm Marketing Cooperatives Return Sav- 
ings to Patrons. Donald R. Davidson. FCS 
Research Report 7. 1970. 81 pp. 

A Financial Profile of Farmer Cooperatives in 
the United States. Nelda Griffin. FCS Research 
Report 23. 1970. 95 pp. 

How The Adjustable Revolving Fund Capital 
Plan Works. Nelda Griffin. FCS General 
Report 111. 1963. 8 pp. 

Methods and Policies Used in Making Patronage 
Refunds By Selected Cooperatives. Donald R. 
Davidson. FCS General Report 137. 1966. 22 pp. 

For copies, write Farmer Cooperative Service, 
U.S. Department of Agriculture, Washington, D. 
C. 20250. 



UNIVERSITY OF FLORIDA 



3 1262 08500 2094 




FARMER COOPERATIVE SERVICE 

U.S. DEPARTMENT OF AGRICULTURE 



Farmer Cooperative Service provides research, man- 
agement, and educational assistance to cooperatives 
to strengthen the economic position of farmers and 
other rural residents. It works directly with coopera- 
tive leaders and Federal and State agencies to 
improve organization, leadership, and operation of 
cooperatives and to give guidance to further 
development. 

The Service (1) helps farmers and other rural resi- 
dents obtain supplies and services at lower cost and 
to get better prices for products they sell; (2) advises 
rural residents on developing existing resources 
through cooperative action toenhance rural living; (3) 
helps cooperatives improve services and operating 
efficiency; (4) informs members, directors, 
employees, and the public on how cooperatives work 
and benefit their members and their communities; 
and (5) encourages international cooperative 
programs. 

The Service publishes research and educational 
materials and issues Farmer Cooperatives. All 
programs and activities are conducted on a nondis- 
criminatory basis, without regard to race, creed, 
color, sex, or national origin.